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Monthly Archives: September 2013

Does Debt Matter? Yes, it matters in a BIG way whether it is public-sector (government) debt or private-sector debt. Both the absolute amount & the debt-to-earnings ratio matter. And they matter a LOT!

And so, it is a good thing that there is so much discussion about the rising level of federal government debt in the USA.

Several unhelpful refrains are that public-sector debt is not big deal since, unlike private-sector debt, it can be endlessly rolled over or can be repaid with freshly-printed money.

And, never mind. We only owe it to ourselves & it is dutifully being held in our pension accounts! Anyway, interest rates are so very low that the cost of borrowing is negligible.

Alas, such silliness has been passed off as wisdom when uttered by Nobel Laureates & other mainstream economists. In turn, journalists & opinion makers have been co-conspirators in peddling this nonsense.

There are many reasons to worry about the continued expansion of fiscal deficits & government debt. Eventually, the amount & proportion of debt will reach a tipping point whereby an additional unit of debt cannot generate additional economic growth. At this point, stagnation will set in.

When debt (private or public) is used to support non-productive current spending, instead of promoting growth, it sets into motion a cycle of wealth destruction in the real economy. In other words, borrowing is used to repay interest or to cover operating expenses without adding to future revenue streams.

According to a Deutsche Bank study, the G-7 spent $18 to generate $1 of GDP over the past 5 years. For their part, G7 countries added almost $18 trillion of debt, including almost $5 trillion new liabilities on the balance sheets of their central banks, that generated only about $1 trillion of nominal GDP. Now the total debt of these countries is at a record high of $140 trillion so that their total consolidated debt-to-GDP ratio is 440%.

All the spending led to mushrooming deficits, debt and a troubling expansion of central bank balance sheets with little to show in terms of economic growth. In turn, the economic & financial systems have become increasingly fragile with small upward movements of interest rates likely to cause a massive adjustment.

Concerning the cost of debt, bond yields cannot remain artificially-low forever. Unfortunately, such low interest rates have encouraged an irresponsible accumulation of outstanding debt that will lead to enormous funding problems when unsustainably-low yields eventually increase.

Meanwhile, government borrowing has diverted funds away from private investing while the painfully-low interest rates have discouraged saving. This ongoing “financial repression” accompanied by attempts to impose new taxes or raise rates on existing ones to finance public spending comes at the expense of shrinking disposable household income & savings.

In sum, it ain’t a pretty picture.

A clearer way to look at the ongoing accumulation of debt is that has increased the accumulation of risk.

The most obvious risk is that the inevitable increase in servicing costs of public-sector debt will leave less for governments to spend out of existing tax revenues. And it is unlikely that the private sector can absorb an increased burden of taxes since higher interest rates are likely to trigger more foreclosures or bankruptcies, leading to lower tax revenues.

Support for imposing ever-increasing tax rates (or new taxes), especially on the “rich”, reveals a twist of logic that contradicts many precepts of economic analysis.

Consider President Francois Hollande that would increase the marginal tax rate on French citizens to 70%. Such proposals are made as though incentives don’t matter; that actions do not have consequences.

How naive is he to imagine that taxpayers will not respond by either engaging in evasion or finding legal means for avoidance. And then there is the extreme act of avoidance. emigration, an act undertaken by France’s richest person, Bernard Arnault, who filed for citizenship in Belgium.

Punitively-high tax rates suggest that public officials should judge the limits to success. Earnings within a competitive market economy can only occur by providing goods or services that are valued by the broad community. In this sense, earnings are rewards granted by consumers to those that add value to their life & are a matter of merit.

Imposing different tax rates on individuals based upon income violate a basic premise of the “Rule of Law” that all laws should apply equally to all individuals, Basing differential tax rates on income is no less arbitrary than requiring women to pay higher rates than men; tall people to pay higher rates than short people, etc.

If the purpose is to boost revenues for government, coercive redistribution is a poor substitute for passing laws that facilitate increased opportunities for exchange that can lead to higher economic growth rates. As it is, much of the recent reduction in the size of the fiscal deficit of the US federal government has come from higher tax revenues due to economic recovery, however weak it has been.

In all events, governments that would demand a right to impose higher tax burdens on productive individuals ought first provide good-faith efforts to curb waste & fraud in existing public spending programs.

Further, demonizing certain group by creating “them-versus-us” categories (e.g., 99% versus 1%) does nothing to promote social harmony. It is primarily a game that encourages citizens to identify with particular political parties & is a distraction from economic realities.

Finally, assertions that the “rich” do not pay their fair share & should shoulder a greater burden supposes that governments have first claim on citizens’ incomes.

We economists like to explain things using highly stylized models. We build make-believe worlds, populate them with creatures that act according to strictly prescribed rules, and analyze what happens. Or, as my wife said after I described one of my research papers to her: “You really never did stop playing Dungeons and Dragons, did you?”

Such a foolish claim really only depicts what passes for economic analysis of Mainstream (neoclassical) economists. As such, it is not surprising that the bibliographic data for this article does not list a single reference to work by Austrian economists, many of whom anticipated the most recent bubble.

Also unsurprisingly, Williams, President & CEO of the San Francisco Federal Reserve Bank, turns to “pop psychology” that puts the blame on “human nature” rather than the misbehavior of central bankers.

Contrast Williams’ comment with the great pains that Austrian economists take to depict economic activities in their full complexity & dynamic nature.

I await a trigger that will start a great unraveling of the bond market bubble & a (slightly–less) inflated stock market bubble created by “quantitative easing” (QE) that provided liquidity in support of the continuation of excessive borrowing, especially by governments, including China.

According to Liu Yuhui of the Chinese Academy of Social Sciences, heavy borrowing to fuel investment-driven growth caused local government debt to double in just 2 years to about 20 trillion yuan ($3.3 trillion). He also suggests that the amount of government debt at all levels as a percentage of GDP may have risen by about 16 percentage points last year, up from 182% at the end of 2012 & 167% at end of 2011.

But there are also problems with private borrowing. According to Fitch, China’s private-sector debts rose from 129% of the size of the economy in 2008 to 214% at the end of June 2013.

This dependence on borrowings to drive economic growth is unsustainable.

At some moment, this madness must & will stop. Predicting the timing is impossible. It will come as a complete surprise to most when it does. As it is, most people think that central bankers saved the world from an economic & financial meltdown with their meddlesome ways, without questioning the end-game of their ongoing “unconventional” monetary policies.

In actual fact, central bankers have merely set the stage for a worse set of outcomes than if they had let the too-big-to-fail banks go under in 2007-08.

The reason this Ponzi Scheme has been able to survive so long is that almost every country is in on it. In the past, most governments pursued economic and monetary policies based on their own domestic agenda. Internal imbalances (e.g., relatively-high rates of price inflation; balance of trade deficits; etc) would eventually lead to market-driven adjustments (e.g., capital flight; exchange rate revaluations).

Since all countries that matter are doing pretty much the same stupid things, these adjustments have not yet occurred (maybe in India or Indonesia).

There will be a “The-Emperor-Has-No-Clothes” moment when lenders realize that government borrowing cannot go on forever. Greece alone was not the trigger.

But at some point, there will be an interest rate spike in a significantly–large economy that will prompt something like a contagion effect that will affect rates in many others.